1. Turn your investment property into your primary residence
The easiest way to limit or avoid the capital gains tax is to convert your investment property to your primary residence. The reason? If you sell a primary residence, you don’t have to pay taxes on the entire gain. That’s because IRS Section 121 lets you exclude up to:
- $250,000 of capital gains on real estate if you’re a single filer.
- $500,000 of capital gains on real estate if you’re married and filing jointly.
To count as your primary residence, you must own and live in the house for at least two of the five years immediately preceding the sale. Say, for example, that you bought an investment property in 2010, and in 2015 you converted it to your primary residence. In other words, you moved in and called it home. In 2019, you can then sell the property as a primary residence because you lived in it (and owned it) for at least two out of the previous five years.
2. Offset gains with losses
Another way to lower your tax liability when you sell investment property is to pair the gain from the sale with losses from your other investments. This strategy is called tax-loss harvesting.
The IRS aggregates your gains and losses for the year. So even if you sell your investment property at a profit, you can offset those gains by losses you had in, say, the stock market. For example, if you had $53,000 in capital gains from selling your investment property, and in the same tax year had $50,000 in losses from a bad stock investment, your capital gains would be limited to just $3,000.
One caveat to know: The tax code requires that short-term and long-term losses get used first to offset gains of the same type. But if your short-term losses exceed your short-term gains, you can apply the excess short-term losses to any long-term gains. Likewise, if your long-term losses are greater than your long-term gains, you can apply the excess long-term losses to any short-term gains.
3. Take advantage of a Section 1031 exchange
If you want to sell an investment property -- but don’t need to cash out just yet -- you can defer paying capital gains taxes by doing a like-kind exchange.
Section 1031 is a provision of the U.S. tax code that lets you sell an investment property (called the “relinquished property”), buy a “like-kind” property, and defer paying taxes. This process is called a 1031 Exchange, a Starker Exchange, or a like-kind exchange. In most cases, a Qualified Intermediary (QI) acts as a third-party facilitator to ensure the process goes smoothly.
To qualify as a like-kind property, it must be real property (i.e., real estate) that you’ve held for productive use in a trade for business or for an investment. Personal residences don’t count. Neither do vacation homes.
There are strict time limits for 1031 exchanges. After you sell your investment property, you have 45 days to identify up to three like-kind exchange properties.
After that, you must close on the new property within 180 days of selling your investment property, or before your tax return is due for the year you sold the property -- whichever comes first. If you don’t meet these deadlines, the transaction won’t count as a 1031 exchange and any capital gains taxes will become due.
Capital gains taxes can take a big bite out of your profits when it comes time to sell your investment property. Fortunately, there are ways to lower and defer these taxes. Taxes are complicated and rules change, so it’s always recommended that you work with a qualified tax specialist to make sure you receive the most favorable tax treatment possible.